Laddering for higher, more stable returns

When investing in things that pay an interest rate--things like CDs and bonds--it's tempting to try to get the maximum interest rate, and then to try to lock up that rate for as long as possible. There's an alternate strategy that provides good, stable returns with a lot less stress and a lot less need for predicting the future: Laddering.

There are two downsides to locking in a rate:

First, it might not turn out to be a great rate. You could have locked in a record-high 9% in 1979, only to have rates move higher and stay higher--they wouldn't get that low again until 1986.

Second, even if turns out to be a great rate, eventually your bond matures, and then you have to reinvest at whatever rates are then. Just a couple years later, in 1981, you could have locked in 14.5% for 30 years. That did turn out to be a great rate, but those bonds are going to mature in three years. If you had to reinvest them now, you'd only be able to get about 4.4%.

(As an aside, I'll mention that, although 14.5% was a great rate, you'd have done quite a bit better yet if you'd invested in stocks in 1981, rather than bonds. Still, bonds have a place in a portfolio.)

One alternative is laddering. With laddering, instead of putting all your money into bonds of one maturity, you buy a series of bonds or notes that mature over a period of time. (In treasury securities, ones that mature within 10 years are called notes and longer-term ones are called bonds.)

For example, you could put one-tenth of your money into notes maturing each year of a ten-year period. That way, you're less likely to lock in a poor rate for all your money, plus you're not exposed to the risk that rates will be unusually low at the moment you have to reinvest.

Setting up a ladder takes some effort, or at least some persistence.

It's possible to set up a ladder all at once, if you do it in a brokerage account. You could, for example, buy ten notes, one maturing next year, one the year after, and so on. (My old on-line broker actually had an option to construct a ladder and buy all the bonds at once, but I can't find an option like that with my current brokerage account.)

The easy way to do it would be to just buy the bonds one at time over a period of some years. For example, you could buy a 10-year note every year for ten years. Once the ten years are up, you're done--just reinvest each note when it matures. Do it through TreasuryDirect and there's no commissions. If you'd done that over the past ten years, you'd have quite a few notes paying 5% and 6%.

As I say, it requires some persistence--it's easy to fail to follow through for any of a variety of reasons. I had it in my head to set up a ladder of 30-year bonds. I got one in 1994 at 7.5%, and then another in 1995 at 6.88%, but in 1996, due to laziness or inattentiveness, I failed to get my next bond. After that rates seemed kind of low, and I figured I'd wait until they got a bit higher.... Suffice it to say that I do not have the ladder that I'd intended.

A ladder is an especially good choice if you're investing for income that you're going to live off of. If you had the 10-year ladder I described, your first bond, which had been earning around 5.5% will have to be reinvested this year at current rates--around 3.5%. That's more than a one-third drop in the income from that bond. But, since it's just one-tenth of the ladder, the total income from the entire ladder will only drop by a few percent. If rates stay down for several years, your income will go on falling, but at least you'll have a period of time to either lower your cost of living or else find another source of income.